The Case for Cash Flows

When earnings and cash flows are different, as they are for many projects, we must examine which one provides a more reliable measure of performance. We would argue that accounting earnings, especially at the equity level (net income), can be manipulated at least for individual periods, through the use of creative accounting techniques and strategic allocations. In a book, entitled Accounting for Growth which won national headlines in the United Kingdom and cost the author his job, Terry Smith, an analyst at UBS Phillips & Drew, examined 12 legal accounting techniques commonly used to mislead investors about the profitability of individual firms. To show how creative accounting techniques can increase reported profits, Smith highlighted such companies as Maxwell Communications and Polly Peck, both of which eventually succumbed to bankruptcy.

The second reason for using cash flow is a much more direct one. No business that we know off accepts earnings as payment for goods and services delivered; all of them require cash. Thus, a project with positive earnings and negative cash flows will drain cash from the business undertaking it. Conversely, a project with negative earnings and positive cash flows might make the accounting bottom line look worse, but will generate cash for the business undertaking it.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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